French elections: step two (parliament) as important as step one (president)

When it comes to the French presidential elections, it seems that many investors have their reading glasses on when they should be looking into the distance with their binoculars. While the presidential elections makes for great political theatre, regardless of who gets elected president, it will do little to overcome the legislative challenges faced by France. Parliamentary elections are just two months away, the results of which could make the country unmanageable.

First, let’s have a look through the reading glasses before putting on the binoculars. Sunday’s election is too close to call with the four main contenders close in the latest opinion polls:

• Emmanuel Macron 23%
• Marine Le Pen 22.5%
• François Fillon 19.5%
• Jean-Luc Mélenchon 19%

Source: Sopra Steria

What makes predicting the result difficult is that the classic “left-right” divide amongst voters no longer exists. This has been a growing trend in elections across the developed world and France is no exception. Perhaps this is the reason – or at least one of the reasons – that political opinion polls in recent elections have been more Inspector Clouseau than political science. Let’s not forget that the opinion polls in the party primaries for the presidential elections were also wrong.

Now, let’s take, a look through the binoculars towards the June parliamentary elections, because that’s when things could get very tricky. In the parliamentary elections any candidate who polls above 12.5% of the vote goes on to the second round. Previously, it has tended to be only two candidates in a constituency who made the cut. This year promises to be very different, as the rise of the En Marche! party of Emmanuel Macron split the Socialist party into two distinctly different camps. When there are three candidates in the second round of parliamentary elections, it is called a triangulaire (a quadrangulaire is an extremely rare event); in the 2012 legislative election out of a total of 577 seats, only 34 ended up in a triangulaire. In the upcoming June elections, the figure could be as high as half. This would be an unprecedented situation likely to result in a splintered parliament with no clear majority, and make governing the country difficult. It’s not a rosy picture.

The prevailing uncertainty makes for very nervous investors, and wherever sweaty palms and jittery fingers waltz over a Bloomberg keyboard, volatility will inevitably ensue. To hedge our portfolio against a potential spike in risk (political in this instance) we seek convexity which will perform well in a risk-off scenario and inflict only limited, and known, losses if we are wrong. An asymmetrical pay-off which currency options provide achieves this.

Currently, we are short the euro vs the US dollar as we feel that upcoming events in France could lead to higher volatility and a weaker single currency, either now or going into the June parliamentary elections. As can be seen from the chart below, the curve steepens (gains for the portfolio increase) as the euro weakens. If, on the other hand, results of the elections are to the market’s liking, a sigh of relief is likely to be accompanied by a stronger euro. A strengthening of the single currency would generate a loss on the option position, but limited only to the amount of premium paid. This potential loss (the premium) is known in advance.

However, the objective of a diversified portfolio is to have several different performance motors on the go at the same time. In the instance of a positive set of elections results in France leading to a strengthening of the euro (loss of the premium), we would also expect our long Portugal and credit positions (financial euro subordinated debt, amongst others) to perform well and counter-balance the weaker euro position.

Hervé Hanoune – Head della boutique Fixed Income – Vontobel AM